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SUBSCRIPTION LINE FINANCING IS ‘THE TELL’

“The word “Snake” has lost much of its derisive character, but there was a time when the term (from “Snake Eater”) was a taunt reflecting on the-purely imaginary-diet of the West Virginia Mountaineers.

In some of the factories the departments sometimes “worked in a pool”; that is, the earnings of, say, men working on a bias cutter were pooled and all shared alike in the total piece work pay. The Snakes, told about the pool, were known to report to work in high hip boots.” A.W. Jones “Life, Liberty, & Property”

I’ve taken my shot at Private Equity and was very disappointed Warren Buffett did not comment on it at Berkshire’s 2017 annual meeting in the same manner he did with hedge funds last year1. Therefore I’ll add some fuel to the fire.

I believe astounding PE returns are fictitious and institutional investors are misguided in using those returns as the basis for reinvesting in PE. That is if the returns are even available. As I have analyzed and outlined, the logic doesn’t make sense. In fact, the returns are so incongruous from an efficient-market hypothesis, and the lack of granularity encompassing them so opaque, that they have a Madoff like quality about them.

Thus it was interesting to read six months ago about a heretofore unfamiliar term to this capital markets veteran, called Subscription Line Financing (SLF). No furor arose then, nor several months later when elaborated upon further in a Bloomberg article questioning its use, and I am of the belief that the journalists are not fully aware of what they’ve uncovered. That’s probably because the decision-makers, aka institutional investors and consultants, also don’t have a handle on the full ramifications of what SLF means vis-a-vis their underlying portfolio. As an example of this let’s examine a snippet from the aforementioned Bloomberg article:

“Jim Herrington, head of private and public equity investing at the West Virginia Investment Management Board, said he doesn’t see the practice as a big problem. He puts pension cash that hasn’t been invested yet into index funds, so it doesn’t sit idle.”

Do you think that Jim is aware that the “cash” he’s putting to work in index funds is now doubly exposed to both whatever index it is in2and the heavily levered company the PE firm has chosen to utilize SLF for? That’s right, the minute that bank line is drawn upon for the purchase the pension system of the State of West Virginia has full recourse for their percentage of the debt. If twelve months later the PE firm makes the decision to pay off the Subscription Line Financing and the chosen company has lost 50% of its value, the State of West Virginia still buys that company at its original price, there is no re-negotiating of the deal whatsoever.

Equally worrying, is that none of the participants are fully aware to what extent SLF is being utilized. Probably the best indication comes from this consultant:

“Use has gradually snowballed as firms seek to one-up rivals that employ the lines, said Auerbach of Cambridge Associates. “We’re seeing an arms race.””

Let’s face it, for all the reasons we listed previously, there is no fundamental edge in Private Equity, so one has to assume the gaming of it to keep up appearances is pervasive, fueled by the voracious sales calls and information sharing of the commercial bankers offering the lines.

But it’s not just West Virginia that may not have a handle on what their real returns from Private Equity are. CalPERS, the largest pension fund in the country is also having difficulty ascertaining what their actual costs are for PE according to an article published in Forbes last month:

“officials at CalPERS do not know the full extent of the fees the pension’s private equity managers take out of the pension.

At a 2015 meeting, the chief operating investment officer openly acknowledged that no one knew the performance fees paid.”

Now if CalPERS can’t measure Private Equity fees, what makes one think they can measure Private Equity performance correctly? Because even without the distortions of SLF, the timings and goings (capital calls/payouts/exits/redemptions) over many years and over numerous funds are very difficult to track, and I think that PE firms have the upper hand in dictating what their performance is stated to be. Additionally, it’s very enticing for investors not to dig too hard and take it at face value, because the supposed good performance makes them look good to their trustees. Furthermore were it to be incorrect it’s not their fault and probably won’t be discovered anyway.

In fairness, if the largest pension fund might not be able to measure performance correctly, then maybe it’s not right to point the finger solely at The Snakes of this country. Through the abuse and overuse of Subscription Line Financing and opaque and questionable performance, all investors may have been deceived by PE firms. Or maybe it’s self-deception?